Investors Are Playing Russian Roulette

Understanding crowd psychology is a big part of successful investing. So investors’ opinions can be useful on the direction of the market when they’re at extremes. In the August sell-off, both professional and retail investors got nervous and sentiment became way too bearish.

Like clockwork, everyone raced to cash and took their chips off the table.

Then the market took off and zoomed to new highs. I thought the market was overdue for a bounce in September, but stock prices regrouped much faster than I would have thought.

October ended up being the best month for stocks in four years!

So, now that the market has had a nice run, I decided to take a look at several sentiment indicators to see where we’re at today.

First, it’s important to note that individual investors are quite bullish on stocks, and that this generally isn’t good for future market returnrns. At the beginning of 2015, they were 69% invested in stocks, which is the highest investment level since the previous stock-market high in 2007.

Currently, individuals are 66% invested in stocks, meaning that the allocation has come down – but not by much.

How low would the investment allocation have to go for people to move against the crowd and go all in on stocks?

In 2009 the percent invested was just 41% and in 2011 it was 51%, just before a huge move higher into the fourth quarter.

Today, cash levels stand at about 18%. Over the last 28 years, the average has been 23.8%.

Higher-than-average stock allocations and lower-than-average cash on hand typically means sub-par returnrns for stocks until investor sentiment swings the other way.

When you look at them as a group, professionals tend to be way worse than individuals because they’re even more bullish. After the market got hammered in August, for example, professional investors were only allocating 15% to stocks. Now that the market has hit new highs, that number is up to 70%.

That isn’t actually an extreme level. Historically, anything around 72% has yielded annualized returnrns of just 0.5%. Considering that the current dividend yield is about 2%, the returnrns for stocks are pretty much negative.

So what is there do?

Sentiment is high but not outrageously so, and the market has become increasingly bullish as stocks have recovered from the summer slump. That doesn’t mean you should follow suit. The risk to adding to stocks here is high, so be on the alert to cut back existing positions if the market starts to roll over again.

John Del Vecchio

Editor, Forensic Investor